Citigroup to price notes linked to Euro Stoxx 50 index with rare principal-protected structure

By Emma Trincal

New York, June 3 – Citigroup Inc.’s upcoming 0% market-linked notes due June 30, 2022 linked to the Euro Stoxx 50 index represent the latest example of an endangered species of structured notes – products with full principal protection, sources said.

The notes provide one-to-one upside exposure to the underlying index, subject to a cap expected to be set at pricing between 80% and 100%, according to a 424B2 filing with the Securities and Exchange Commission.

If the final index level is less than or equal to the initial index level, the payout will be par.

Endangered species

Only $65 million of products with full principal protection have priced so far this year out of a total volume of $20.93 billion, according to data compiled by Prospect News, a meager 0.31% market share.

With interest rates still very low, issuers have a difficult time pricing those deals, which combine the use of a zero-coupon bond and the purchase of call options. When interest rates are low, the discount to the zero-coupon bond’s face value is “tight,” limiting the potential for upside, sources explained.

In this deal, a few factors may make the notes more enticing, starting with the underlying index, a structurer said.

Euro boost

“There are probably more Euro Stoxx deals in the U.S. than S&P deals. Considering that it’s in the U.S., it’s pretty interesting,” he said.

An example, he said, was last week’s $178.65 million offering issued by Bank of America Corp., a principal-at-risk, leveraged products linked to the euro zone benchmark.

“People are piling on the story in Europe, so those deals tend to be popular,” he said.

Another factors behind investor appetite for Euro Stoxx 50 deals in times of forex volatility, he noted, is that they eliminate currency risk.

“You invest $100 in a structured note tied to the Euro Stoxx or the Nikkei. If the index is up 10%, you get $10. If it’s up 20%, you get $20,” he said.

“You don’t have that with an ETF. Some ETFs offer currency hedging, but it’s never straightforward. They don’t tell you how they hedge; they don’t tell how much they hedge, whereas in structured products, it’s very clear.”

Too long

Regardless of the employed underlying, principal-protected notes have become rare, and factors other than low interest rates are behind this decline, he said.

“I would think that seven-year, 80% to 100% cap is how your typical principal-protection deal is pricing right now,” he noted.

“This one may price. But we don’t see many principal-protected deals nowadays.

“Is it because investors don’t want it? I don’t think so.

“In this case, is the cap the deterrent? I don’t think so either. You get 11% to 13% a year. That’s not unreasonable.

“It’s the long tenor people are not happy with.”

Outside the box

According to this structurer, if investors were more “open,” there would be an easy way to make those structures more enticing.

“The market does not seem to like the idea, but it’s silly. All you have to do is reduce the participation rate,” he said.

“It’s amazing to me when salespeople tell me, No way! American investors won’t buy 80% participation. It’s got to be one-to-one.

“OK, but they’re not buying seven-year products either, apparently.

“Take this deal and instead of offering 100%, give investors 80% of the return. You would be able to raise the cap significantly or shorten the maturity or do a combination of both.

“The fact that there isn’t even a conversation around this is so illogical.

“There is no law that says you need to have 100% participation in the upside.

“When you only buy 80% of the options, think about what you can do with the other 20%. You can buy more calls and raise the cap; you can make the term shorter.

“If people’s perceptions about participation levels could change, I’m sure we would see more principal-protected products out there despite the tough interest rates environment.”

Not competitive

A market participant said that the upcoming deal could have been better priced as is.

“It’s very tight right now to price principal-protected notes. You can’t do it on a five-year anymore with those terms. But on a seven-year and with the Euro Stoxx, you should be able to do it without a cap because it’s already pretty long,” he said.

He pointed to the compounding of dividends over a seven-year period as a source of funding for the options.

“With the Euro Stoxx you get 2.5% a year. That’s 16% interest you can use to buy a call option to give you the upside,” he said.

“You don’t need a cap. Especially if the note is priced in dollars where interest rates are higher than in Europe, you don’t need a cap.”

Tough market

In general, though, principal-protected notes continue to decline. Sales in this product type are down 11% from last year so far this year, according to the data. Volume five years ago was nearly 10 times greater at $607 million.

“It’s still a very tight pricing. It’s difficult to put fees in these structures. The fees are low. You don’t see much of it partly because of that,” the market participant said.

“Even if the dividends take care of increasing or eliminating the cap altogether, you still end up with pretty long durations.”

The economic environment may not be supportive either.

“It’s really a bond replacement product. At the same time, if you think interest rates are going to increase, a seven-year has a high delta to the interest rate variation. It can negatively impact the value of your notes,” he said.

“People still care about duration. You have to take seven-year exposure to the bank’s credit risk. Most people are worried.

“Others don’t have that kind of time. In private banking if you talk to someone who is 70 years old, in seven years, he may be on the other side.”

Citigroup Global Markets Inc. is the underwriter.

The notes are expected to price June 25.

The Cusip number is 17298CBV9.

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